Covered Call: Definition, Strategy and Example

Making an extra premium while you wait for a stock to increase sounds like a dream come true. That's what a covered call does for you. It's not an exact science. There are no guaranteed profits. There are also no limits to your losses. It can be a big risk, but one that may pay off in the end.

Read on to learn about covered calls and when you can use them to your advantage.

What Is a Covered Call?

You can sell a covered call on a stock you own. What you sell is a right to the buyer to buy the stock from you. The buyer buys the option for the underlying stock at a designated price and for a certain period. In order to write a covered call, you must own at least 100 shares of the stock.

When you sell a covered call, you may hear the term 'write a covered call.' When you write a call, you sell it. You are the 'writer' of the option on the underlying stock.

You're covered (or limit your risks) because you don't have to buy the stock if the buyer assigns the option. You already made your investment and own the stock. You also set the strike price and the expiration date. Your risks are very calculated.

Covered Call and Risk

A covered call lowers your risk. You are not at the mercy of the market price of the stock. You already own it. An exercised contract is no longer a big risk. You'll have to sell your stock, but you know the price at which you'd have to sell. An exercised covered call usually results in a slight profit, especially if you sell it at a strike price that you are willing to sell the stock. You are aware of the maximum profit ahead of time, though.

It's an options strategy for a trader who feels slightly bullish about the underlying stock's position. You think the stock price will increase, but only slightly. You don't expect to make too much on the stock. In order to increase your profits, you write or sell the covered call. You make the premium plus any profits you make if the call is assigned. Don't forget though, the call can expire worthless. If it does, you walk away with the buyer's premium. A covered call won't make you rich, but it may provide a little more income than straight stock ownership would provide.

Short Call

Writing covered calls differ from writing short calls. When you write a covered call, you own the underlying stock. If the call is assigned, you are 'covered.' A short call means you do not own the stock. You sell a 'naked call.' This works best as an out of the money options strategy. If you sell a very out of the money call, chances are it will expire worthless. You walk away with a small profit (the premium). No stock traded hands.

However, keep in mind, if the market price of the stock goes the opposite direction than you thought, your loss is unlimited. In other words, the risks are very high.

Why Should You Sell a Covered Call?

Why would you want to obligate yourself to sell a stock you own? It's all about the profits. It's a strategy that does have risks, though. You limit your profits. It has to be a position you are okay with taking. Luckily, you can calculate your maximum profit ahead of time. This should help you choose the right investment option.

Looking at the basics of the covered call, you make a premium, but still own the stock. Here's an example:

You own 100 shares of ABC stock. You paid $50/share, or $5,000. You write a covered call with a strike price of $55. You receive a premium of $2.50, or $250 ($2.50 x 100 shares). The call has an expiration date of 3 months. In 3 months, the market price of ABC stock is $52. The call expires worthless. You keep the premium and your stock.

In this case, it looks pretty black and white. You own a stock that is worth more now than when you bought it. The buyer let the call expire worthless. Plus, you get to keep the $250 premium from the option on the underlying stock. If you sold your position right now, you'd make $450 profit:

If you didn't sell the call, your investment would have only made you $200 from the stock price increase. You also have the option to hold onto the stock. You don't have to sell it. If you feel bullish about the stock, you could keep it and hope for larger profits.

Now let's see what would happen if the stock price increased even more, though.

Let's say the stock price reached $60. The buyer would then assign the call, giving him the right to buy the underlying stock. You would have to sell your shares at $55. You lose your stock position. But, here's what your profits would look like:

In this case, you didn't get your cake and get to eat it too. You had to give up your stock ownership. You did walk away with a premium, though.

Try to sell a covered call at a strike price that is your liquidation price. At what price would you jump on the chance to sell it in the open market? This way, if the stock is assigned, you are happy with your profits and make a decent income.

Another reason to sell the covered call is to earn money on a decreasing stock. Let's say, for example, the stock price dove to $48 from the $50 you paid. You want to hang onto the stock and see if it makes a comeback. In the meantime, you can sell a covered call for your desired strike price. You collect the premium upfront. You know upfront that the call may expire worthless. If the stock never hits the strike price, you walk away with a small profit and your stock. This small profit may help offset the risks of a declining stock.

If the stock hits the strike price, you have to sell it. This is one of the largest risks of the covered call. However, if you sold the call at your liquidation price, you should be okay with the trade.

As you get more experienced, you can dabble in options for securities other than just stocks. ETF and forex options are great alternatives. However, you should make sure you have enough experience in stock options before trying your hand at more complicated choices.

Protecting Yourself with a Covered Call

There's no magic formula to help you decide the right price to sell a covered call on an underlying stock. You know what you paid for the stock and how much return you would like to make. You set the strike price based on that amount.

You might want to focus on medium volatility stocks. This gives you a 50/50 chance at selling a call that expires worthless.

For reference:

High volatility stock: The stock's price can significantly change in a short period. The change can be positive or negative.

Low volatility stock: The stock's price will remain stagnant or change very little in the near future. Again, if it does change, it can be positive or negative.

Medium volatility: This is a stock somewhere in between the high and low volatility stocks. It's not expected to have any drastic movements.

You should understand implied volatility when choosing your options strategy. The IV lets you know the predicted change of a particular stock over the next 12 months. The likelihood of the IV ringing true is 68% or one standard deviation. For example, if the IV is 20%, the stock could increase or decrease 20% over the next year. This gives you 'boundaries' or 'guidelines' to help determine how much a stock may change over the next year.

Focusing your options strategy on medium volatility stocks gives you a higher likelihood of the call expiring worthless. You walk away with the premium and the stock in your hand. This may not drastically increase your current income, but it puts a little cash in your pocket. Plus, you still remain a stockholder because you didn't have to sell the stock.

Other Choices When Selling a Covered Call

Investors don't want to sell the stock upon option assignment because the market is doing too well

Investors don't want to hold onto the covered call any longer

Holding Onto Your Stock Investment

Investors who want to hold on to their stock position may have another choice. You may be able to buy the stock at the current market price. You can then use that stock to sell if the call doesn't expire worthless. Two things must happen first. You must talk to your stock advisor ahead of time to make these arrangements. In other words, you'll need funds in your brokerage account to buy the underlying stock and sell it right away.

You'll also need to see if it makes sense to do so. You'll want to make more on the original stock investment than the loss you take on the covered call. Buying the shares in the open market and selling at the strike price will likely result in a loss.

Here's an example:

You originally bought XYZ stock at $50/share. You wrote a covered call with a strike price of $55 and 3-month expiration. You made a premium of $3, or $300.

At the 3-month mark, the stock rose to $60 per share. That's much higher than you predicted. You see an instant $1,000 gain on your stock position. Plus, you think the stock may go higher. Rather than selling those shares, you buy stock on the current market. Here's how it looks:

This situation would only happen to investors who actively watch the market and know when to move, though.

Reversing Your Options Strategy

You may also decide you don't want the call option any longer. In this case, you may buy the call on the underlying stock back. Of course, you'll have to see if it makes sense to do so. You'll want a premium that is lower than what the buyer paid you. If you wait until close to the expiration date, you'll likely nab it for a much lower premium. This way, you still make a small premium, but keep your stock.

Other Options Strategies to Consider

Once you have a little more experience under your belt, you may want to dabble in other options strategies. While slightly more complicated, they give traders more choices:

Long put - When you buy a put, you invest in a long put. You have the 'right,' but not the obligation to sell. This is different from writing a covered call. Remember, writing means you have the obligation. When you go long on a put, you feel bearish about the stock. You think its price will decrease. If it does, you have the right to sell at the higher strike price and walk away with the profit.

Short put - When you sell a put, you invest in a short put. Because you are the writer, you have the obligation to buy the stock if it hits the strike price. However, you feel bullish about the stock. You think it will increase. If it does, the holder will not execute the option because he can make more on the open market with the higher price. A short put is also known as a naked put.

Long call calendar spread - This investment strategy involves two options - a short call and a long call. Both options typically have the same strike price. The difference is when they expire. The long call usually has a later expiration date than the short call. You use this option when you think the stock won't change much in the near-term, yet will increase in the long-term. If the price remains neutral, your short call expires worthless. You keep the premium. This offsets the premium paid for the long call. If the price then increases as predicted, you can exercise the long call and make a profit.

Bear calendar put spread - This investment strategy involves 2 put options. You sell a put with a short-term expiration date. You choose a strike price near the current market price of the underlying stock. You feel neutral about the stock in the short-term. If the option expires worthless, you keep the premium. This offsets the cost of the long put. You feel bearish about the stock in the long run, assuming it will fall in price. If it does, you exercise your right to sell the stock at the higher strike price. You then profit on both legs of the option strategy.

You can also try your hand at multiple leg options. The iron condor, butterfly, and straddle are options of options with multiple options within one strategy. For example, with the iron condor, you buy and sell both a call and a put. This strategy limits both your profits and your losses. The butterfly and straddle also involve multiple legs; however, the straddle has unlimited profit potential.

Bottom Line

In a perfect world, the stock would hit your exact strike price and not a penny more at expiration. The call expires worthless. You keep the premium and also realize the stock gains.

Of course, we don't live in a perfect world. We live in a world where stocks are unpredictable. Selling a covered call requires research, time, and patience. It also requires catlike reflexes when things don't go the way you thought. Call strategies don't always turn out as planned.

Utilizing the services of a great broker can help. Your stock advisor can help you learn when it's right to sell a covered call on a stock you own. It has the potential to make you a little extra money. It also has the potential to limit your profits more than you'd prefer.

Do your research and carefully evaluate your position before deciding if this option is right for you.

Disclaimer: Opinions expressed here are author's alone. Please support CreditDonkey on our mission to help you make savvy decisions. Our free online service is made possible through financial relationships with some of the products and services mentioned on this site. We may receive compensation if you shop through links in our content.

More from CreditDonkey:

Options Trading

You think a stock's price will increase, so you want in on that trade. What if you didn't have to fork over the entire amount of capital? What if you could pay a much smaller premium and still make money?

About CreditDonkey® CreditDonkey is a stock broker comparison website. We publish data-driven analysis to help you save money & make savvy decisions.

Editorial Note: Any opinions, analyses, reviews or recommendations expressed on this page are those of the author's alone, and have not been reviewed, approved or otherwise endorsed by any card issuer.

†Advertiser Disclosure: Many of the card offers that appear on this site are from companies from which CreditDonkey receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). CreditDonkey does not include all companies or all offers that may be available in the marketplace.

*See the card issuer's online application for details about terms and conditions. Reasonable efforts are made to maintain accurate information. However, all information is presented without warranty. When you click on the "Apply Now" button you can review the terms and conditions on the card issuer's website.

CreditDonkey does not know your individual circumstances and provides information for general educational purposes only. CreditDonkey is not a substitute for, and should not be used as, professional legal, credit or financial advice. You should consult your own professional advisors for such advice.